Hedge Funds — Distressed Debt Investing

Last time we looked at the overall category of event-driven hedge fund strategies, which includes risk arbitrage and distressed debt investing.

The second category, distressed debt investing, seeks to take advantage of special opportunities that arise when companies in financial trouble undergo restructuring.

In these situations, the various classes of lenders in an organization (senior bondholders, etc.) fight over who gets what, while the equity shareholders are usually left with nothing.

The distressed debt specialist tries to buy debt at a deep discount, betting that it will be worth more when the restructuring process is completed. For example, he may buy the bonds of a distressed company at 25 cents on the dollar, hoping to double his investment or even get full face value of $1 if the company is restructured effectively.

This bond investing strategy is quite different from other bond strategies. Instead of seeking steady income over time as many bondholders do, the distressed debt investor is looking for a short, quick gain in a bond’s price.

Distressed debt investors usually buy two kinds of bonds: 1) “stressed” bonds that still pay interest, but the company issuing them is having trouble paying its debts; and 2) defaulted bonds which are no longer paying interest but which may rise in price and thus provide a capital gain. Both types of bonds trade at a deep discount to their original face value. And as a company’s financial problems get worse, the price of its bonds may fall even lower. If a company goes bankrupt, the bonds are considered “defaulted” bonds.

It’s important to remember that even if a company goes into bankruptcy, the bonds may still have value. Chapter 11 of the U.S. bankruptcy code allows companies to reorganize their finances while under protection from creditors. The goal is to avoid Chapter 7, an overall liquidation of the company.

Even in bankruptcy, there is a definite “pecking order” as to who gets their share of the remaining assets, starting with senior, secured credit holders on down to equity shareholders. But professional distressed debt investors who buy defaulted bonds expect to see the value of their bonds increase during the reorganization process.

Distressed debt investors have sometimes been referred to as “vulture” investors, picking over the carcass of a dead company. But they are not responsible for the financial mess the company is in. And in fact, distressed debt investors play an essential role in the reorganization process by providing liquidity to more traditional bond investors.
References:

Jaeger, Ph.D., Robert A. All About Hedge Funds, The Easy Way to Get Started. McGraw Hill, 2003.